How Japan Is Creating a Template for Cryptocurrency Regulation

Some countries in Asia are feeling the pain of inadequate cryptocurrency regulation, while others, like India, China and South Korea, have taken an uncertain or hostile stance to cryptocurrency. In contrast, Japan is building a clear framework for how virtual currency exchanges, and soon initial coin offerings (ICOs), should operate there. In doing so, Japan is becoming a hotspot for virtual currency exchanges that can afford to comply with its strict rules, while also creating a regulatory template for the rest of Asia to follow.

Japan has always been friendly to cryptocurrency, but it took an early hit in 2014 when Tokyo-based cryptocurrency exchange Mt. Gox became the target of the largest bitcoin hack ever. The exchange was handling 70 percent of all of the bitcoin transactions in the world when, after a series of messy complications, it abruptly stopped trading in February 2017. Following that, 650,000 bitcoin worth $390 million at the time (or $6 billion at today’s value) were reported missing.

In response to the massive virtual currency heist, the Financial Action Task Force (FATF), the Paris-based international body that creates policies to combat money laundering, issued its “Guidance of Risk-Based Approach to Cryptocurrencies” in 2015. The 46-page report recommends that countries license virtual currency exchanges and subject them to the same rules and oversight as any other financial institution or money transmitting business.

New Laws, Big Changes

Prompted by a desire to protect consumers and the FATF’s recommendations, Japan revised its Payment Services Act. The new law, which went into effect in April 2017, does two things. First, it legally defines virtual currency as a form of payment. (Japan still does not define bitcoin as legal tender, but acknowledges that you can use it to purchase things with.) Second, the law requires any virtual currency exchange that wants to do business in Japan or solicit its citizens to register with the country’s Financial Services Agency (FSA).

Because existing exchanges needed time to bring their operations up to date with the new standards, the FSA gave all exchanges that were in operation before the law went into effect a six-month grace period to apply for a license. Any exchange that applied for a license within that period was allowed to continue operating for an indeterminate period of time while their application was still pending. These exchanges fall under a special category of “quasi-operators,” meaning they are not fully licensed operators, just somewhere in between.

Under the new law, virtual currency exchanges in Japan are now required to be accountable to their customers. They have to keep customer assets separate from the assets of the exchange, maintain proper bookkeeping, undergo annual audits, file business reports and comply with strict know-your-customer and anti-money-laundering rules, and more.

First Licensed Exchanges

Registering as an exchange in Japan is a long, involved process that can take up to six months. The FSA licensed the first 11 exchanges in September 2017. In early December 2017, it licensed another four, and at the end of December 2017, it licensed the 16th exchange. At that time, 16 quasi-operators still had applications pending and were in the process of upgrading their internal operations. Then, in late January 2018, disaster struck. Coincheck, one of the quasi-operators, was hacked, resulting in the loss of $530 million worth of NEM tokens.

The Coincheck theft prompted heavier oversight. The FSA began conducting on-the-spot inspections for all quasi-operators to look for security gaps, and in March 2018, the FSA sent out punishment notices to seven exchanges, even requiring two to halt operations for 30 days.

According to Asia News Network, the FSA is grappling with how to handle its quasi-operators. Shutting unqualified operators down too quickly could cause customer backlash, but, at the same time, the FSA needs to make sure the proper security checks are in place.

Japan’s plan is to pass on part of the work of overseeing virtual currency exchanges to a self-regulating body (SRO) that functions similarly to how the Financial Industry Regulatory Authority (FINRA) works in the U.S.

To that end, in April 2018, the Japan Virtual Currency Exchange Industry Association launched. The new group, comprised of the first 16 licensed Japanese virtual currency exchanges, will have the power to create and enforce rules and set fines, and eventually develop standards for ICOs.

Legalizing ICOs

After tackling virtual currency exchanges, Japan is now moving on to the ICO market. The process began in October 2017 when the FSA issued a statement warning investors about the volatility of ICO tokens and the risk for fraud. In that statement, the FSA also clarified that, depending on how an ICO is structured (and whether its token has the characteristics of virtual currency or an investment), it may fall within the scope of the Payment Services Act or the Financial Instruments and Exchange Act.

In April 2018, the Center for Rule-Making Strategies at Tama University released a list of guidelines for regulating ICOs. The government-backed report states that ICO projects should clearly spell out how they plan to distribute funds. It also outlines rules for tracking the progress of a project, confirming the identity of buyers and restricting insider trading. According to Bloomberg, the proposal will be deliberated by Japan’s FSA and could become law in a few years.

Japan is still fine-tuning oversight of its virtual currency exchanges, and its ICO framework may take a few more years to develop. But, by putting clarity around an industry that has long operated with little or no oversight, Japan is setting the stage for a future when cryptocurrencies will play a larger role in society.